My not-so-profound thoughts about valuation, corporate finance and the news of the day!

Wednesday, February 1, 2017

January 2017 Data Update 8: The Dark and Light Sides of Debt

There is no aspect of corporate finance where morality plays a bigger role than the decision of how much to borrow. That should come as no surprise. For generations, almost every religion has inveighed against debt, with some seeking outright bans and others strongly urging followers to "neither a borrower nor a lender be", and perhaps with good reason. History is filled with instances of human beings, caught up in the mood of the moment, borrowing money and then finding themselves destitute in bad times. That said, there is no denying that the decision of whether to borrow money, and if so how much to borrow, has become a critical part of running a business.

The trade off on debt

In corporate finance, the discussion of debt begins with an examination of the trade offs on using debt, instead of equity, to finance operations. I have described debt as a double-edged sword before, and running out of analogies, I am going to draw on Star Wars framing, and talk about the light side (benefits) of debt and the dark side (costs) of debt. In the course of the discussion, I want to separate the illusory benefits and costs of debt from the real benefits and costs, partly because I see them mixed up in practice all the time.

In terms of the real factors that drive the trade off, debt creates two benefits. The biggest comes from the tilt in the tax code, which allows interest expenses to be tax deductible and cash flows to equity to be not. The secondary benefit is that debt can operate as a disciplinary mechanism, with the discipline of having to make debt payments restraining managers from taking truly abysmal projects. These benefits have to be offset against two big costs, the first and biggest being the increased likelihood of distress and the second being the potential for disagreements between lenders and equity investors about the future of the firm (and how it plays out as debt covenants). All of these factors show up in the cash flows and risk assessment of a business. There are however illusory factors that can be distracting. On the benefit side, there are some who argue that debt is good because it can push up your return on equity or point to the fact that the cost of debt is lower than the cost of equity. Both statements are generally right, but the flaw in reasoning in both is that they assume that as you borrow more money, your cost of equity will remain unchanged, and it will not. In fact, in the absence of debt and distress, the positive and negative effects will offset each other, leading to no value change. On the cost side, debt detractors will note that the interest expenses associated with debt will lower net income, ignoring the fact that the lower net income is now being earned on a lower equity base. If the argument is that debt will increase default risk and the cost of debt, it is worth pointing out that even at the higher cost, debt is still cheaper than equity. Finally, there are transient factors that come from market frictions, where if your equity is mis-priced or the interest rate on your debt is set too low or high (given your default risk), you (as the company) may take advantage of the friction, using more debt if equity is under priced and debt carries too low an interest rate and less debt if equity is over priced and debt carries too high a rate. This, of course, will require CFOs of companies to embark on that most dangerous of expeditions, of judging market assessments of their value and risk. The picture below brings together all of the elements:

As we debate why companies borrow money and how it affects their value, it is good to be clear eyed about how debt changes value. It is almost entirely because of the tax benefit that it is endowed with, and if you take that tax benefit away, the reasons for borrowing quickly dissipate.

The Cross Sectional Distribution

Before we embark on an examination of debt loads across companies, let's start by looking at three different measures of financial leverage:

Debt to Capital = Debt/ (Debt + Equity): This is a measure of how much of the capital in a company comes from debt. It can be measured as accountants see value (with book values for debt and equity) or as the market sees it (with market values for debt and equity).

Debt to Equity = Debt/Equity: This is a close variant of debt to capital, with debt stated as a percent of equity, again in book value or market value terms.

Debt to EBITDA = Debt/EBITDA: This measures how much debt a company has relative to the cash it generates from operations, before taxes and capital expenditures.

In computing my total debt for the 42,668 companies in my sample, I include all interest bearing debt (short term, as well as long term) as well as the present value of lease commitments (which I treat as debt, and which accountants will start treating as debt in 2018 or 2019). I will start by looking at the distribution of debt to capital ratios, in both book and market terms, across all companies:

A large percentage of firms, more than 25% in the US and almost 20% globally, have no debt. Regionally, on a market debt to capital ratio, Eastern Europe(with Russia) and Latin America are the most highly levered regions of the world, but in terms of debt as a multiple of EBITDA, Canadian and Chinese companies have the highest debt burden.

I follow up by looking at debt to capital ratios for companies, by country, in the picture below and the statistics for all four measures of leverage in this spreadsheet.

Latin America and Eastern Europe remain the most indebted region in the world, with almost every country in each region having debt ratios of 30% or higher in market value terms and often 50% or higher in book value terms. While some of this can be attributed to the drop in commodity prices over the last few years, I think that one reason is that many Latin American companies are hooked on a combination of high (and often unsustainable) dividends and a desire for control (manifested in an unwillingness to dilute equity ownership). The same factors explain why many Middle Eastern companies, where there is no tax benefit from debt, continue to borrow money.

Industry Differences

You would expect companies in different sectors to have very different policies on financial leverage, and most of the differences have to do with where they fall on the debt trade off. In the table below, I list the most highly levered and lightly levered non-financial service sectors in the United States, in terms of market debt to capital ratios.

There are few surprises on this list, as you see technology sectors (software, online retail, semiconductor, semiconductor equipment and electronics) on the least-levered list and capital intensive sectors (power, trucking, telecom) on the most-levered list. It is interesting that integrated oil/gas companies are among the least levered sectors but oil/gas distribution is on the most levered list. If you want to see the full list of industries, not just for the United States but also for other regions of the world, try this spreadsheet.

Closing

In my earlier post on taxes, I noted that 2017 is likely to be a year of change, at least for the US tax code and almost every version of tax reform that is being talked about will reduce the marginal tax rate and therefore the tax benefits of debt. In fact, there are some versions where the entire tax benefit of debt will be removed. While I believe that this will be healthier in the long term for businesses, it will be a seismic shift that will have massive effects not just on corporate borrowing but on the corporate bond market. I am not sure that we (as investors and companies) are ready for that big a change. So, small steps way from the status quo, which is skewed strongly towards borrowers, may be all that you can expect to see!